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Uncertainity Replaces Euphoria

The IDBI downgrade brings credit quality in sharp focus, even as bond fund returns sober down

Y V Reddy was a villain turned hero for bond markets this week with a statement that government borrowing would not exceed the budgeted target. The golden words perked up sentiment, which was derailed after markets realised that there was little hope for an immediate rate cut. An on-track-borrowing programme means comfortable liquidity with little pressure on yields.

The week started off with a spurt in call rates as the system reeled under the impact of last week's OMO of Rs 5,000 crore. The beginning of the reporting Friday meant demand pressure as well with overnight rates touching 7.7 per cent on Monday. However, aided by burgeoning deposits, active lending by state banks saw the call rates tapering off by the weekend. While there was marginal interest in repo deals, there was hardly any transaction under reverse repo, which means that liquidity was just comfortable. The rupee continued to move in a narrow band and seems to have stabilised in the 47.12-47.15 band.

Even as Gilts recovered from the last week's tightening, the sentiment in the corporate segment received a big jolt when CRISIL downgraded lending major, IDBI from AAA to AA+. The downgrade sent a ripple effect across instruments of financial institutions with IDBI paper losing an average Re 1 in the next trading session. Coming on the backdrop of UTI fiasco, which has shaken the faith in Government owned institutions, the downgrade does not augur well for PSU banks.

There was little to cheer on the economy front with RBI Governor pulling down GDP growth estimates to 5.5 % against the earlier forecast of 6%. In sync with RBI revision, JP Morgan also revised its growth estimate to 5.3% for the current fiscal. The re-kindling of economic growth now hinges on the mercy of rain gods. While the Government has been harping on a turnaround, the signals from the economy are far from encouraging. For instance, the corporate tax collection for the first quarter was down by 63% at 1737.11 crore. Thus, in the light of falling tax collections and no alternative sources of revenue, the government's pump priming without additional borrowing seems to be a distant dream. The political compulsions of the government (the forthcoming elections in the crucial state of Uttar Pradesh) could put further pressure on the precarious finances.

Outlook
While prices have largely recovered, an element of uncertainty has crept into the markets. With receding hopes for a rate cut, there is no factor to trigger aggressive buying despite a surfeit of liquidity. Thus, prices could stabilise at current levels. Further, with stability coming back, the RBI is likely to come up with another auction shortly.

The last week's sharp losses have already seen a dip in weekly returns from bond funds. The one-week return for July 19 is only 0.30 per cent against 0.55 per cent for the week ended July 6. Thus, do not invest in the lure of extraordinary returns since an encore is unlikely as gains from capital appreciation slowdown. Add to it, the IDBI downgrade has brought into sharp focus the issue of credit quality, especially in a deteriorating economy. As returns now even out, it is important to keep a close tab on your bond fund's portfolio and redeem if you are not comfortable with your fund manager sacrificing quality for higher returns.